A Geek’s Guide To The Financial Melt-Down

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How Did We Get Into This Financial Mess?

Man – what a mess! I’m almost afraid to unwrap the paper each morning because the font size of the headlines seems to be getting bigger and bigger as the financial news gets worse and worse. Stock trading firms are going belly up, others are getting bought. Fannie Mae and Freddie Mac (who are they?) got taken over by the government and now WaMu just failed. Clearly this is the end of the world. Maybe.

As a reasonably gifted technical person, I thought that I knew how the world of finance worked (and so to apparently did a lot of people who worked in finance); however, with the wheels coming off of the truck, now I’m not so sure. I really needed someone to explain to me just how so much could go so wrong so quickly. And that’s where Stephen stepped in.

Stephen Schwarzman is a true Master of the Universe in financial circles. First off, he’s a billionaire. Secondly, he’s the chairman and co-founder of the Blackstone Groupprivate-equity firm. In case you aren’t aware of it, Blackstone is HUGE and they only play with numbers that end in “Billion”. So when the Wall Street Journal and the Yale School of Management hosted a round table of important people in finance, he was there.

Stephen started what was intended to be a Q&A session with an (almost) all-in-one-breath summary of just what the heck has happened to the financial markets. For geeks who like their technical information short & sweet and preferably from a guru, you’re not going to get much better than this. Here’s the whole quote:

It’s a perfect storm. It started with Congress encouraging lending to lower income people. You went from subprime loans being 2% of total loans in 2002 to 30% of total loans in 2006. That kind of enormous increase swept into a net people who shouldn’t have been borrowing.

Those loans were packaged into CDOs rated AAA, which lead to the investment-banking firms [buying them] to do little to no due diligence and the securities were distributed throughout the world where they started defaulting.

When they started defaulting, out of bad luck or bad judgment, we implemented fair-value accounting… You had wildly different marks for this kind of security, which led to massive write-offs by the commercial-banking and investment-banking system.

In the face of those losses… you needed to raise new equity…which came from sovereign-wealth funds, in part, which then caused political resistance to sovereign-wealth funds, who predictably have withdrawn from putting money into the system… It seemed pretty obvious that would have to happen. We now find ourselves with a liquidity crisis where fundamentally the cost of money for financial intermediaries [such as investment banks] is significantly in excess of their cost of lending it. So several institutions found themselves in a structurally impossible position… Goldman reverted to a banking charter for a lower cost of funds, which today is still not low enough for the business. So that is the story of how we got here.

Whew! All that in one breath? The man truly knows his stuff. If you got all of that, then you can stop reading now and you are fully prepared to be the star of the next cocktail party that you go to this week. However, if like me some of what Stephen said sailed over your head, then let’s take a few moments and do a some debugging and see what he was really getting at. Maybe if we step through what he said line-by-line it will make more sense:

It’s a perfect storm. It started with Congress encouraging lending to lower income people. You went from subprime loans being 2% of total loans in 2002 to 30% of total loans in 2006. That kind of enormous increase swept into a net people who shouldn’t have been borrowing.

Congress enacted the Community Reinvestment Act (CRA) in 1977 in order to encourage banks to extend loans to qualified people with low incomes. Home loans are actually divided into four different categories: prime, jumbo, subprime and near-prime mortgages. Everything is based on your credit risk: if you have a stable job and a good credit rating, then you can get a prime mortgage (lower interest rate). Jumbo loans are generally of prime quality, but they exceed the $417,000 ceiling for mortgages that can be bought and guaranteed by government-sponsored enterprises – basically if you are buying a McMansion then this is the kind of loan you’d take out. Near-prime mortgages are made at a higher interest rate than prime, but lower than subprime. These are for folks who may not be able to document their income or may have trouble providing a down payment. Subprime loans are for folks with poor credit ratings and risky sources of income. These loans carry the highest interest rates.

Things percolated along quite nicely and non-prime loans made up about 9% of all home loans being made up through about 2001. Then BANG! Two things happened: some clever mortgage banker devils decided to change how they calculated a person’s credit worthiness – they started using the same rules that were used to get auto loans (these were looser rules – it was much easier to get a loan). But wait, there’s more! By itself, just making it easier to qualify for a home loan would not have been enough to cause subprime loans to surge from 9% to 40% of all home loans being made in 2006. There had to be something else…

Once again, it was clever bankers to the rescue. See, it turns out that in order for a bank to make a loan, they need to have equity capital on hand to back those loans up (that’s what they are loaning out). When you run out of this, you’ve got to stop making loans and that means that you’ll miss out on making all that money that banks make when they process mortgages (remember all those “fees” when you bought a house?). What banks really like to do is to sell a mortgage to investors after they’ve completed the paperwork. This way it’s off their books and they’ve got more money to loan out. Hmm, the problem was that these subprime mortgages were too risky to sell to traditional investors. What to do? Sure seems like its time to invent a new financial vehicle to take care of this.

Those loans were packaged into CDOs rated AAA, which lead to the investment-banking firms [buying them] to do little to no due diligence and the securities were distributed throughout the world where the started defaulting.

Oh, oh – it’s vocabulary time. Remember, banks made prime mortgages funded with deposits from savers (you and me) and then sold them to investors. Near-prime and subprime mortgages presented a bit of a problem – no investor was going to touch them because they were too risky. This is where CDOs come in.

A Collateralized Debt Obligations (CDO) is a clever investment tool that was created to make investing in subprime mortgages easier for investors to stomach. What happens is that a lot of subprime mortgages were sold by banks and mortgage originators (non-banks that were handing out mortgages) and then these loans were stuck together into a CDO. Inside a CDO, individual loans were placed into one of three “trenches”: senior (pretty safe), mezzanine (sorta safe), and equity / unrated (uhh – I’m not so sure about this). Each trench paid a different interest rates with the higher risk trenches paying more to compensate investors for the higher risk. Got it so far?

What Stephen is talking about is that this all sorta works if there is a mix of loans (good/bad/ugly) in a CDO. What happens if they are all ugly? It turns out that these beasts are fairly complex and it’s quite difficult to accuracy determine how risky one of them is. The guys who are supposed to be good at doing this, the credit rating agencies (Moody’s, Standard & Poor’s), apparently were asleep at the wheel. An “AAA” rating basically means that an investment is a “sure thing” – its rock solid. They classified a lot of CDOs as being AAA when they were really made up of too many subprime morgages. Oh oh!

Things starting hitting the fan when folks started missing their mortgage payments on their subprime loans. This resulted in default rates shooting up. Hold on – this is where things start to get bad. Defaulting subprime loans then started to cause CDOs that were based on them to stop generating returns to investors (if nobody is making their monthly loan payments, then there is nothing to pass on to investors). All the clever tricks that had been set up to make sure that CDOs could withstand some defaults crumbled when it turned out that lots of CDOs were made up of all high risk subprime loans.

When they started defaulting, out of bad luck or bad judgment, we implemented fair-value accounting… You had wildly different marks for this kind of security, which led to massive write-offs by the commercial-banking and investment-banking system.

So the sky started falling. What made things get so bad so quickly? Well this little accounting trick called fair-value accounting sure didn’t help things. What this means is that the value of a CDO is based on the current market price for that CDO (whatever someone is willing to pay you for it right now). When the financial world started to turn upside down and the loans that made up lots of CDO started to turn out to be worthless, that meant that the value of the CDO itself started a race to $0. This is what caused the U.S. government to have to step in and save Fannie Mae and Freddie Mac they were backing too many bad loans.

When you are an investor and your investment has become worthless overnight (ouch!), what do you do? You write it off – you tell the world that your gold has become lead and you’ve just lost a lot of money. This happens all the time and everyone hopes to move on and do better next time. However, this time around lenders reacted to these signs by tightening credit standards especially on riskier mortgages.

When it became hard for everyone (prime, subprime, etc.) to get loans, people stopped buying houses. This meant that it became much harder to sell a house. This meant that if you got behind in your house payments then you couldn’t just sell the house and make yourself whole. You basically HAD to default on your loan and just walk away.

This meant that the banks and financial institutions could no longer raise money they way that they had been doing even as their investments turned to dust. Can you say cash flow problem? The perfect storm had arrived.

In the face of those losses… you needed to raise new equity…which came from sovereign-wealth funds, in part, which then caused political resistance to sovereign-wealth funds, who predictably have withdrawn from putting money into the system… It seemed pretty obvious that would have to happen.

So if you are a Lehman Brothers, what do you do now? You start cluching at straws. Your next best source of cash is what is called a Sovereign Wealth Funds (SWF). SWFs are typically created when governments have budgetary surpluses and have little or no international debt. A good example of a SWF is the Kuwait Investment Authority – lots of money looking for a home that will generate more money. Having foreign governments make big investments in the firms that control big parts of the U.S. economy made our elected officials in Washington D.C. very nervous. To make themselves feel better, they passed the Foreign Investment and National Security Act of 2007. Basically, this gave the government veto power over any deal that involved a SWF. The SWFs said, ok – if you are going to be that way, then we’ll go play somewhere else. If you were WaMu, then you just saw your last best chance for funding to save yourself walk away!

After this, everything just went to hell in a handbag. It’s not over yet. However, here’s the final take away that Stephen didn’t cover. Everything will work out in the end. What needs to happen is that the credit markets that businesses and people borrow from have to unfreeze. Once this happens, then people will start borrowing again (rationally we hope). Then investers will return and start to make investments. Life will once agian get back to normal. Grit your teeth and we’ll get though this together.

What do you think about the financial mess that we’re in? What do you think that this will mean in the long run for IT? Do you think that the computers and software that all of the banks and mortgage lenders used should have warned them that things were going to go wrong? Do you think that technology can save us from having this ever happen again? Leave me a comment and let me know what you are thinking.